Posted by Robert on September 27, 2010
Last week, we held an evening presentation in our office. The presenters are real estate investors who have been doing a great job producing impressive returns for our clients over the last eight years. I had a chance to chat with them before and after the presentation. They provide an interesting view from inside the real estate investment world. It seems that often, the word “investment” is applied to real estate projects in the loosest sense of the term. Our friends told us that these “deals” have shown up in Calgary more than anywhere else in Canada, that they are aware of. Maybe it’s all the oil money sloshing around. I know that none of our readers have more money than brains, but I’d still like to point out some of the red flags that should cause an investor to ask tough questions before parting with hard-earned cash.
The first point that our friends made is the difference between an offering memorandum and a prospectus. I had this experience when a client asked me to look at an “investment” that his family members recommended to him. He asked the promoter for the investment documents, and was provided with the marketing sheet. That didn’t help, so I prompted him to ask for the prospectus or offering memorandum. A prospectus is used when the investment is regulated by the national regulator (IIROC) and syndicated through securities dealers. In that case, the regulator and dealer each vet the investment to ensure it contains full and accurate disclosure (not necessarily that it’s suitable for a given investor). An offering memorandum, on the other hand, is not required to contain complete information. It cannot contain misrepresentations, however.
The offering memorandum that I read through for my client offered a lot of information. It disclosed the fact that the property in question was purchased for about $2 million and was being resold to investors for about $10 million. On top of this markup, a commission of 10% was being paid to anyone who promoted the investment. There was also a fee (around 2%, if I recall) paid annually for “asset management”. There was a $50,000 minimum and the prospective investor was asked to sign a form acknowledging that they understood the high risk nature of the investment and were able to withstand the loss of the entire amount. Standard CYA, I’m sure, but enough to give a person serious pause. I didn’t make a recommendation for or against the investment. I only asked my client to read through the offering memorandum cover-to-cover before investing. He decided against participating (and I’ve never heard how his family members fared).
Another issue that caught my attention, in the offering memorandum, was the blatant conflict of interest. The person who was promoting the investment had no real estate experience, although he had partnered with someone who did. Together, they bought the property, put together the investment (remember the markup?), formed a promotion company to sell it (remember the commission?) and formed a management company to manage the asset (remember the fee?). Further, they formed a subsidiary corporation to issue the debt, so they could say it was guaranteed. The guarantee of the subsidiary of the company that’s selling you the investment is worth less than the paper it’s printed on. All these conflicts of interest ensure that the promoters get paid multiple times before the investors see a cent of profit.
So, what is the potential for profit? I wasn’t entirely clear, but the marketing materials explained that the profits were shared. The promoters structured the deal so that there were bonds and shares. The bonds attracted interest, but no profit. The shares could receive dividends and profit, upon successful completion of the project. The promoters bought only shares, at a reduced price. If the value of the property grew from the price the promoters paid, beyond the price the investors paid, covered the commissions, the asset management fees and the interest on the debt, then there would be profits to share between investors and promoters. That’s a big “if”.
There are many things to watch out for when someone is pitching you an investment deal. Why doesn’t your advisor want you to know about it? Probably because it’s too good to be true. If you’re thinking of investing a large sum, make sure you read and understand the offering documents, or at least get a qualified second opinion. Which brings me to why I like working with our friends. They always make sure the investment is a good deal for investors. There is very little up front cost, investors get paid first and I’ve even seen them skip payments to themselves, so that there would be less chance of anything going wrong with the project. That kind of reputation is extremely valuable.
What do you look for when making an investment or participating in a project? What kind of people do you prefer to work with? How do you find them?